Tax-Loss Harvesting: From Traditional Strategies to Direct Indexing

Tax Loss Harvesting 1.0, 2.0, and 3.0

Tax loss harvesting 1.0 is selling investments that have declined in value to "lock in" the loss that you can use to offset any other capital gains.

For example: Mutual Fund ABC goes down $100,000, you sell ABC and swap it for mutual fund XYZ (or wait 31 days and re-buy ABC, see wash sale rule). You now have a $100,000 loss that you can use. You have a stock, a real estate investment, or the sale of a business that generated $100,000 in capital gains. You can use your $100,000 loss that you realized to offset the $100,000 capital gain and your tax bill is $0. If you have no capital gains, you can use up to $3,000 per year to offset your regular income and carry forward the remaining $97,000 loss to future years.

Tax Loss Harvesting 2.0 is rather than owning the mutual fund, you own the individual stocks in the mutual fund.

For example: If mutual fund ABC goes up $100,000 for the year, you have no losses to capture. However inside of that mutual fund may be 1,000 individual companies. Let's say 500 of those companies had a loss of $100,000 and 500 of them had a gain of $200,000, in total you have the same $100,000 gain as the mutual fund. You sell the 500 companies that generated a $100,000 loss and even though overall you had a gain, you get $100,000 of losses to offset any realized capital gains.

Tax Loss Harvesting 3.0 is more complex as it adds both owning the individual stocks and shorting individual stocks. Shorting means if the stock goes down, you make money.

In 2.0 is you only get losses if stocks fall.

In 3.0, you have losses both when stocks fall and when stocks rise. The stocks you bought have losses if they fall. The stocks you shorted, have losses if they rise.

This, along with using leverage, can create significant capital losses. Estimates show you should expect: Year 1: 30% of your investment in losses Year 2: 47% By Year 5: 80% In more levered portfolios the losses can exceed your initial investment

For example: You're planning to sell your business in 5 years and expect to have a gain of around $800,000. If $1,000,000 is invested today, by year 5, the strategy would have produced $800,000 in losses, completely offsetting the capital gain While your $1,000,000 is still expected to get around market returns.

Alternatively if you don't have the liquid investments to invest right now: Ideally you sell your business, stock, or real estate in January Take the proceeds and put it into the strategy to give yourself 12 months to start generating losses to offset the gain from the sale

The ideal situation is: You have a single stock that has significant gains that you want to diversify away from, but don't want to pay the capital gains tax. Use one of these strategies to capture losses and sell your stock to offset the gain. Business owner looking to sell a business that will have significant capital gains Real estate investor that has significant capital gains from sale of real estate

1.0 You could likely do on your own. However there are windows where had you not tax loss harvested on 1 particular day and got into a different investment on that same day the opportunity was gone the very next day.

2.0 and 3.0 are typically done through Advisors. As far as I am aware it is difficult, or impossible, to get into these strategies without an Advisor, especially 3.0 Fidelity recently announced they are pausing new applicants into the 3.0 strategy due to volume constraints. For context, this strategy jumped from $10billion in it, to over $80 billion in it in 18 months Schwab is still offering it. Our relationship with Focus Partners, a $500 billion investment firm, gives us access to this for our clients. There is a minimum of $1,000,000 to get into 3.0. There is risk, complexity, and expenses associated with this strategy. Due diligence should be done before entertaining this.

Investment Tax Documents

All investment tax documents should be available in the Custodian's website now. 1099s for Brokerage accounts 1099-Rs will be in your Traditional IRA for back door Roth conversions or RMDs taken If you need help, let me know